Ignorance certainly isn’t bliss when it comes to anything in personal finance, and that’s especially true for taxes. Sure, you can hire someone to complete your tax returns for you. But you are the one making the day-to-day decisions that will impact the numbers that ultimately go on the tax form.

Now that your taxes are probably already finished for this past year, this is the perfect time to take a closer look at how much you’re really paying and what you can do to proactively reduce your marginal tax rate.

I’ve worked with hundreds of clients in my career as a tax professional, and there’s a difference between the most successful people and those that are simply getting by financially. Those that understand at least the basics of how money and taxes work are able to make better financial decisions as a result. Even just knowing enough to realize that there are some potential tax implications and reaching out to us made a big financial impact.

The progressive tax rate system in the U.S. can be very confusing, but it’s essential to understand.

A Brief Tax Overview

You likely have at least some familiarity with the basics of how taxes work, but let’s first quickly look at the big picture.

The government requires us to pay taxes to support services and functions that are necessary for the country as a whole. This includes things like the military, building and maintaining infrastructure, social services, etc.

The general rule is that you are simply required to pay taxes on all of your income. There are a few income items specifically exempted in the IRS code from being taxed, such as money received as a gift or inheritance or most life insurance proceeds.

In addition, there are other items that the IRS allows you to defer tax on such as 401k and IRA contributions.

The government then allows you certain specific deductions against your income, which are there to incentivize desired behaviors. These include things such as contributing to retirement accounts, buying a home (via mortgage interest and real estate tax deductions) and donating to charities.

These calculations ultimately determine your taxable income, which is the total of all your income not exempted from taxes (or deferred into the future) less your allowable deductions.

Your taxable income is the key number used to calculate how much tax you owe the government each year. For more information about calculating taxable items, you can check out my (free) mini-class TX301: Income Tax Basics.

Calculating Tax Owed

Let’s assume the following example:

Lisa works for a large engineering firm during the entire 2018 calendar year. Her husband, Mark, is currently a stay-at-home dad. Her W-2 will show taxable wages of $181,250 for the year.

In addition to salary income, they also earn $500 in interest income, $1,500 in (qualified) dividend income and $5,000 in long-term capital gains from stock sales. They contribute $5,500 to a traditional IRA for Mark.

Lisa & Mark’s total taxable income is calculated as follows:

Taxable Wages

$181,250

Interest Income

500

Dividends

1,500

Capital Gains

5,000

IRA Contribution

(5,500)

AGI (Adjusted Gross Income)

$182,750

Standard Deduction

(24,000)

Taxable Income

$158,750

With that taxable income number as the base, we can then use the published tax rates to calculate the tax owed. This is where it starts to get a bit complicated.

Ordinary Tax Rates

The U.S. has a progressive tax system, which means that the tax rates increase with higher income levels. That means that even those that make significant amounts of money are still taxed on the lower rates for the lower portion of their income. Someone that has taxable income of $50,000 and someone that has taxable income of $500,000 will essentially be taxed the same exact amounts on the first $50,000, assuming that they having the same filing status.

It’s important to note that when you reach the next incremental tax rate, only the portion of income that is over that next threshold is taxed at the higher rate, not all of your income. This is widely misunderstood.

The ordinary tax rates apply to all income other than qualified dividends and long-term capital gains.

In our example, Lisa & Mark have $152,250 of ordinary taxable income ($158,750 less $1,500 qualified dividends and $5,000 long-term capital gains). Referring to the married filing joint tax tables, the taxable income of $152,250 lies within the 22% tax bracket (hint: this is the marginal tax rate).

The calculation of tax on ordinary income (see the Married Filing Joint tables) for Lisa & Mark is as follows:

The first $19,050 of taxable income is taxed at 10% ($19,050 x 10% = $1,905)The next $58,350 ($77,400 less $19,051) of taxable income is taxed at 12% ($58,350 x 12% = $7,002)The next $74,850 (the remaining amount of the $152,250 total) of taxable income is taxed at 22% ($74,850 x 22% = $16,467)Total taxes on income at ordinary tax rates = $25,374

Capital Gain Tax Rates

There is also separate tax rate system that applies to income from qualified dividends and long-term capital gains. This is one way that the government favors investment income over earned income. The capital gain rates apply after factoring in the income from before, with the ordinary income filling the brackets first.

We know that total taxable income is $158,750. We filled up the tax brackets first with ordinary income (in our example $152,250), but we can see that there is still plenty of room in the 15% capital gain tax bracket for the extra $6,500 of qualified dividends and long-term capital gains. This income will all be taxed at 15% (without these preferential rates, it would have been taxed at the 22% rate).

Note that if ordinary taxable income items would have been below $77,200, the portion of the qualified income that still resulted in total taxable income of less than that amount would have been taxed at 0% (that’s an amazing rate!). So for example, if taxable income for a couple with married filing joint status is $80,000 and $70,000 represents ordinary income items and $10,000 represents qualified dividends, $7,200 would be taxed at 0% and the remaining $2,800 would be taxed at 15%.

Combined Tax Rates

Now we calculate the following total taxes when we add up tax from both the ordinary and capital gain tax rates:

The first $19,050 of taxable income is taxed at 10% ($19,050 x 10% = $1,905)The next $58,350 ($77,400 less $19,051) of taxable income is taxed at 12% ($58,350 x 12% = $7,002)The next $74,850 (the remaining amount of the $152,250 total) of taxable income is taxed at 22% ($74,850 x 22% = $16,467)
The $6,500 of qualified dividends and long-term capital gains are taxed at 15% ($6,500 x 15% = $975)Total taxes = $26,349

To show the impact that a higher marginal tax rate makes, here is a graph that shows the total income and total tax for this example. You can see that there’s only slightly more income in the 22% bracket than in the 12% bracket, but there is nearly twice as much tax paid on it.

How Your Marginal Tax Rate is Useful

So what exactly is the marginal tax rate? It’s the rate of tax that you’ll pay on your next dollar of ordinary income. Essentially, it’s the highest regular income tax rate from the calculation above.

For the example listed above, the marginal tax rate is 22%. This means that if Lisa and Mark were to have additional wage or interest income, it would start out being taxed at 22%.

You can see this example by comparing the overall tax brackets for ordinary income and capital gain income to the taxable income below:

Generally, whether you prepare your own taxes using a software such as TurboTax or H&R Block, or have them professionally prepared, you will receive a summary that clearly lists your marginal tax rate.

However, it’s really important that you know how tax brackets work because while that next dollar will be taxed at the marginal rate, additional income might push you into the next tax bracket.

Note: this is a simplified explanation of marginal tax rates, as there are things such as phase-outs on deductions that may make the marginal tax rate slightly different than simply looking at the tax brackets.

ABOUT ME

I'm Kathryn Hanna-wife, mother of 3, a Christian and a Certified Public Accountant. I love to budget (really, I do!), build spreadsheets and spend money on travel, sewing supplies and good chocolate. Read More…

Subscribe below to join the 12 Month Financial Plan challenge for 2018 (with an amazing printable broken down by month) and to receive monthly updates, tips as well as other great resources for improving your finances!

Let’s Connect

More about the author

I'm Kathryn Hanna-wife, mother of 3, a Christian and a Certified Public Accountant. I love to budget (really, I do!), build spreadsheets and spend money on travel, sewing supplies and good chocolate. Read More…

My Latest Pins

COPYRIGHT

All images, text, spreadsheets and files are property of the Making Your Money Matter blog. All free printables and file downloads are offered for personal use only. Please link back to my website blog posts for any file downloads and not directly to the files. Thanks!